Investors shouldn’t finance races to the bottom

I just read Albert Wenger’s post about profit destroying innovation and am left wondering if we are entering a period where startups are tearing down incumbents but won’t become sustainable companies in their own right. We have become very efficient at creating super fast growth companies with low or non-existent potential profitability from their existing revenue models. These are often marketplaces with 0% take (i.e. they don’t charge for listings or purchases) or SaaS companies giving away features that competitors charge for in the hope of charging for something else later.

As Bill Gurley wrote recently:

it is materially easier to take a company to substantial revenue if you generously relax the constraint of profitability. Customers will love you for giving away more value than you charge

The dangerous dynamic we should be avoiding is financing businesses to substantial revenues that won’t eventually generate significant profits. That’s happening increasingly often as late stage investors pay up handsomely for high growth businesses without clear/credible strategies for reaching positive cash flow. These un-profitable startups undermine the profitability across entire markets in a way that may not be recoverable. Albert Wenger’s said the same thing differently when he wrote the benefits of innovation are accruing to customers rather than providers. When that happens it is investors who foot the bill.

  • Tunde Yusuff

    Interesting thoughts Nick. As someone who is raising seed investment at the moment, I feel that unprofitable startups are born out of initial bad behaviours encouraged by investors themselves. It seems number of users far outweighs revenue/profitability in how attractive a startup seems to angels and early stage VCs.

  • http://www.theequitykicker.com brisbourne

    It’s difficult. There’s a balance to be struck (obviously). Some entrepreneurs complain VCs weight to heavily on revenues. Others say they weight to heavily on user numbers. That said, it’s definitely true that some investors give bad advice.

  • http://www.alanodea.com alanodea

    This has has happened more in games than any other industry and as we try and rebuild enterprise on mobile and across platforms well see exactly this point hold true.